By James Hamilton, J.D., LL.M.
In the wake of recent market events, the SEC’s Director of Investment Management reminded advisory firms managing hedge funds that they have a fundamental duty to value appropriately and fairly even if a vehicle or account is not subject to the Investment Company Act’s valuation requirements. In remarks before the CCOutreach national seminar, Andrew Donohue also said it was important that chief compliance officers and compliance professionals go back and review the disclosures that have been made to clients regarding valuation procedures.
As part of this review, he continued, compliance professionals should make sure that those valuation procedures are consistently implemented in accordance with the disclosures provided to clients. In the current market conditions, he reasoned, both compliance officers and regulators alike should have a heightened awareness of the importance of valuation and its impact on advisory clients. The director also mentioned the special compliance concerns related to fixed income investments and derivatives. In terms of valuation, investments in fixed income securities and derivative instruments present unique challenges for compliance officers that may not be readily apparent.
In earlier remarks before the Investment Company Institute, the director focused on the need to move from historical models of risk management to a new dynamic reflecting the advent of operational risk and new complex investment products, such as OTC derivatives. Historically, a common approach has been to develop complicated algorithms to guide risk management systems and procedures.
In developing these algorithms, firms took into account the details of past negative events and account for the circumstances that ultimately led to their occurrence. As a result, over the years these algorithms have become finely tuned to address the known risks and contingencies that have occurred over time.
Using such an historical approach may have been appropriate in the past, he noted, when the risks were narrowly-defined and generally known. But now, operational contingencies cannot always be categorized and losses can result from a complicated mix of events, making it hard to predict or model contingencies.
Firms have shifted their focus to the more amorphous area of operational risk. Recently, the Basel Committee set forth a definition of this new area of risk focus as being the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events. Even with this definition, opined the SEC official, it is still difficult to nail down as to what it exactly entails. Indeed, its undefinable nature is what makes operational risk all the more daunting to manage.
The development of complex investment products have caused operational risk to arise as constraints in the back-office threaten important functions, such as managing the settlement, valuation and confirmation processes. In addition, the escalating trading volume of complex derivative instruments has put tremendous constraints and exposed weaknesses in firms’ systems for clearing complex products.